Institutional Investors Warming Up to Alternatives

Institutions participating in the
survey currently have, on average, 22% of total fund assets in alternative
investments. Diversification was cited as one of the top three reasons for
using alternatives by 90% of respondents, while volatility management and low
correlation to traditional investments was mentioned by 64%, and return potential
was noted by 45%.

Additionally, the majority of
respondents indicated that allocations would remain static or increase over the
next one to three years across all alternatives categories. Thirty-two percent
of respondents expect to increase their investment in hedge funds and private
real estate, 28% in private infrastructure, 25% in private equity (PE), 20% in
commodities, and 12% in public real estate and public
infrastructure.

At least 30% of respondents
indicated they were below their target weights in hedge funds, private real
estate and private equity, while traditional investments – cash, fixed income
and equities – were more frequently over their target allocation than under
their target allocation. Cash, specifically, is over-target for 45% of
respondents, which may indicate that they are being cautious about taking risk
and waiting for the right time to reposition cash.

Forty-nine percent of respondents
who participate in hedge funds currently utilize the fund of funds structure
approach. This is more than double the percentage of that for any other hedge
fund implementation method, however, this year’s survey shows respondents
anticipate making shifts away from the traditional fund of funds model. Only
17% of respondents using hedge funds expect to utilize this traditional
structure for implementation over the next one to three
years.

While fund of funds vehicles are
anticipated to lose ground, all other implementation methods are expected to
gain. Additionally, 63% of survey respondents are obtaining customized hedge
fund solutions to complement existing exposures, pursue niche opportunities and
access strategy-specific expertise.

(Cont...)

Consistent with previous surveys,
private equity is more prevalent in North American portfolios, although Europe
is not far behind. In both North America and Europe, more investors are
currently committed to small/medium buyout funds than to larger funds.
Significantly, both North American and European investors expect small to modest
decreases in their current PE commitments over the next one to three years.
Co-investments and alternative energy are expected to show the largest
increases in commitments over the same time period.

Listed real estate investment trusts
(REITs) and unlisted private real estate funds continue to dominate as
implementation choices, with 51% of the respondents (who hold real estate
currently) using them. Only 38% of these respondents, however, said real estate
funds will continue to be an implementation choice in the next one to three
years. Allocations to direct property investments (23%) and customized separate
accounts (15%) are expected to rise in the near future.

Even with inflation-sensitive
characteristics, commodities remain a niche solution and future possibility
(more than a current reality) for most institutional investors. Among the small
sample of survey respondents who hold commodities (32 in number), long futures
exposure is the most popular type of investment (63%), with private equity (44%)
and hedge funds (28%) trailing. Long/short strategies and funds have not yet
made much of an impact (23%), but interest in them is rising, with 46% of
current commodity investors expecting to add long/short over one to three
years.

Although
public and private infrastructure investments command only a small share of
institutional assets (just 1% of the combined asset allocations of all
respondents), many signs point to growth. Private infrastructure investments
appear to be attracting a growing portion of institutions’ illiquidity budgets,
perhaps taking assets away from private equity.

(Cont...)

Boards and trustees are demanding
more education about alternatives and are becoming more receptive to proposals
that have included education. Given the dynamic nature of the alternative
investment marketplace, 36% of respondents indicated that additional education
about alternatives is needed within their organizations.

Russell has observed a growing
respect among North American (NA) investors for comprehensive due diligence
since its 2010 Survey. In the 2012 Survey, 91% of NA investors said they
require comprehensive operational due diligence before making new investments
(vs. 68% globally). Responses to this line of questioning signal a trend in
institutional investors’ approach to working with external resources. Even some
sophisticated investors have decided that they could better achieve their
investment objectives by combining the expertise of internal and external
resources to manage multi-strategy alternatives.

Between January and March, 146
institutional investors in North America, Europe, Australia and Japan
representing a total of $1.1 trillion in assets completed the online
survey.